Definition

The financial investing term normal yield curve refers to an upward sloping line plot used to illustrate the interest rate differences between short and long-term debt instruments. Debt securities issued by the U.S. Treasury Department typically exhibit a normal yield curve, whereby the interest rates paid on securities with shorter maturities is lower than rates paid on debt with longer maturities.

Explanation

Also known as the term structure of interest rates, yield curves are typically used depict the relationship between interest rates and the time to maturity of a debt security such as a bond. The shape of the curve provides the analyst-investor with insights into the future expectations for interest rates as well as possible increases or decreases in macroeconomic activity. Yield curves are line plot showing the term, or maturity, on the x-axis (horizontal axis) and the corresponding rate of interest, or yield, on the y-axis (vertical axis). When plotting a yield curve, the securities should be of similar, if not identical, credit quality.

There are several types of yield curves, and the shape of the curve provides the analyst-investor with insights into the future expectations for interest rates, as well as possible increases or decreases in macroeconomic activity. As the illustration below demonstrates, a normal yield curve has a positive slope that is asymmetrical; the returns on longer maturities increase at a progressively slower rate. This shape has at least three possible explanations:

Risk Premium: the longer the maturity of an investment, the greater the likelihood that an event will negatively impact the investor's return. This type of event can include a sudden increase in interest rates or an issuer going into default on a bond. Investors will want to be compensated for assuming this risk, which is also known as a "liquidity spread."

Risk-Free Rates: investors anticipate an increase in rates; therefore, individuals willing to invest in longer term maturities need to be compensated for this anticipated increase.

Loss of Flexibility: individuals willing to invest in securities with longer-terms lose the opportunity to use that money for other purchases or investments, and will therefore demand higher yields.

Example

The following illustration demonstrates the shape of a normal yield curve.